1.Hopes and Reality of Digital Money

 Hopes and Reality of Digital Money

Never mistake activity for achievement.

John Wooden___

Digital monies are part of our daily life. Payment cards, smartphone apps, and online platforms have become routine ways to make payments, familiar to most of us. A minority of people but a growing one moved ahead, entering the mysterious, ethereal world of cryptocurrencies. Money, once seen and touched, pocketed and handed, now increasingly takes the form of electrons or waves travelling on air and wire at the speed of light, dispatched by a fingertip. The technological upheaval is apparent, but users are typically unaware of what happens below the surface. What has changed? Is it just the fact that payments are easier, quicker, and cleaner? Or are we losing something, together with the materiality of money? Are there pitfalls that ordinary people, even experts, fail to see? What do we need to know and understand, to stay safe in one of the things we care about the most — our money?

If readers feels disoriented, they are not alone. We all are. Disputes about the real nature of the alleged "monetary revolution" are raging. Virtually no week passes without media reporting on news, opinions, debates, initiatives, or controversies around digital money. And this is just the tip of the iceberg: Less visible but equally intense debates take place within closed halls in financial institutions, high-tech companies, official agencies, universities, and circles of experts. Initially concentrated in technologically and financially advanced countries, the phenomenon now garners global attention: Emerging countries often take the lead in the most technologically advanced monetary solutions. Like all activities at the frontier of thinking and innovation, the digitalization of money features its high share of enthusiasm, creativity, experimentation, confusion, and failures.  

In the literature and the press one often encounters expressions like: the payments revolution; the reinvention of money; a new digital; the rise of a new monetary order; governments and central banks better catch up or will be left behind. The atmosphere is one of excitement, especially among newcomers. Legions of high-tech wizards, largely millennials, entered the field thrilled by the prospect of applying their specialist knowledge to a subject that has never failed to inspire fascination and attraction: money. Even more attractive is the prospect of actually making money - a lot of money. In the heyday of crypto markets (2020-21) Bitcoin investors made millions out of nothing: a fortune for most involved, largely youngsters with little more than a laptop, a desk and a chair to sit on. Most of that money was then lost, but this mattered little: The hope of getting rich by pressing a keyboard survived, and the fascination too. Money, fun, and youth, all riding on a revolution. Can you think of anything better?

For those who spent part of their life studying money in academia or practicing it in financial markets or as civil servants, this alleged revolution raises several questions. Can money, one of the most ancient institutions of human civilization, change in such a radical way? If it can, is this a good thing? Can digital money make life better for the ordinary citizen? How can we ensure such an improvement? How should the boundaries between private enterprise and government be designed? Last but not least, what are the risks involved?

Addressing some of these questions inspired us to write this book. As authors, we share two characteristics, of dubious desirability in themselves but helpful in this endeavor. First, we are old enough to have lived through some of the changes in the arrangements and uses of money during and after the second half of the twentieth century. Economic phenomena tend to repeat themselves: historical perspective helps assess novelties and their possible consequences. Second, as part of our professions, we have spent a lot of time thinking about such changes, researching their nature, and working both within and with institutions mandated to promote and defend the collective interest in the realm of money. If, as we believe, money is not primarily a private matter but a social construction essential for the lives of all, then such thinking, research, and work can (indeed should) be put to use to understand the nature and consequences of this new "digital revolution." Here, however, comes an obstacle. Technology is complex, the digital one no less than others. Money, with its theory and practice, is also more complex than it appears at first sight. Yet since the topic is important to all, we wanted our argument to be accessible to anybody, with no more than minimal knowledge in either field. We have therefore tried to reduce technicalities to a minimum and offer our arguments in plain words as if our Readers were complete beginners. At least some of them will be, we hope. We also thought we should not write a heavy tome: This is not a treatise—it is an introduction to the topic shaped by our own views. We have added a number of footnotes with bibliographical references to help readers go deeper if they want. Hopefully, our approach has not gone too much at the expense of correctness and completeness.

Digital money is a catchword for many things. Even traditional forms of money are mostly digital today, and they have been for quite a while. Yet only the newest payment technologies are labelled digital money in the common discourse. Some of them are "cryptocurrencies" because they rely on cryptographical algorithms to produce and exchange value: Bitcoin on top, and countless less well-known ones. Then there are forms of money that are not crypto but still are new and digital. Most of them stem from private initiatives: instruments located at the boundary between money in a proper sense (we will define this more precisely) and payment means, such as Apple Pay, PayPal, Google Pay, and Alipay. We regard those as interesting applications from the viewpoint of facilitating the use of money and enhancing its benefits for ordinary citizens. Then there are officially managed digital monies, still in an experimental or planning phase: the so-called central bank digital currencies, or CBDCs. All these instruments, all different but related, are dealt with in this book.

Given our premises, it should not be a surprise that our journey starts with the history of money. We are not historians, so we enter this terrain at our own risk. But history helps a great deal in understanding what money is and what purpose it serves. It also uncovers its intimate relationship with technology. The link between money and technology, the alternation of long pauses and sudden leaps that characterized the progress of monetary technology, has accompanied the history of civilization. Digitalization is only the most recent step in a sequence of repeated occurrences. 

We deal with the relation between technology and money through ancient and modern history in Chapters 2 and 3. In monetary terms, ancient history lasted about five millennia. Modern times started more or less when telecommunications entered the world of money, in the early twentieth century. Ancient monetary history is fascinating, but the modern one is also enlightening because it illustrates the oft-overlooked fact that the transition to immaterial forms of money (electronic and digital) is much older than commonly assumed. In essence, it was already complete before any of today's "new forms" of digital money (crypto, apps, and the like) even appeared.

Economic theorists have noted that money conveys information - standardized and verifiable information on where value is and how much there is of it. Always and everywhere, information travels on the best available technology. In ancient Mesopotamia, information circulated on clay tablets. The Greeks and the Romans stored that information in coins - that lasted for centuries. After the second century AD, when the information content of coins started to degrade, the Roman world also declined. The combination of paper and printing technology in the Middle Ages, migrating from China to Renaissance Europe, improved upon earlier forms, leading to the birth of the modern monetary system combining private banks handling commercial transactions and state institutions guaranteeing monetary stability. That wasn't an endpoint, because technology constantly evolves. With the rise of electronic and digital communications, it was only natural that money would assume that form, sooner or later.

We articulate these ideas in Chapter 4, where we discuss the economic functions of money. Money is distinct from wealth or productive assets; it is that part which is directly exchangeable for goods and services. Economists argue that money performs three functions: medium of exchange, to procure goods or services that fulfil the people's ultimate needs; unit of account, to measure more easily the terms at which those goods and services are exchanged; and store of value, to maintain over time the possibility to enact those transactions in the future. Some economists have gone further, extending those properties to the encompassing notion of "liquidity value." Money's liquidity value allows the bearer to execute purchases at any time, including unexpected ones, promptly and without value loss or added transaction costs. Seen in this light, money is not only information but also insurance against uncertainty.

Here one departs from economics and enters the realm of psychology - assuming the two are really distinct. By being immediately usable to procure goods and services, money fulfils deeper and immutable human desires: sense of certainty, control of oneself, openness to opportunities, and freedom of choice. Those aspirations are constant throughout history: They will stay with us as long as humans continue to live, own, and exchange. It follows that some of the most basic conditions money is supposed to satisfy are also immutable. It must be easily procurable and usable, immediately recognizable, mutually accepted, simple to understand, and stable in value. These are the characteristics that institutions and authorities, central banks primarily, are to promote and defend. They are the yardsticks we should use to assess the quality of digital money as well.

Chapter 5 deals with the most concrete and material form of money: cash. Cash is the signature product of central banks, an expression of the unique power, exercised on behalf of all citizens, to extinguish obligations by force of law. In earlier times, banknotes embodied a promise of conversion into precious metal; now they only promise to purchase goods and services, and even that at an uncertain price. Today some suggest that the disappearance of cash will follow the rise of digital money; some even argue that cash should disappear. We respectfully disagree with those views. As a matter of fact, cash is not disappearing, except in limited parts of the world. The demand for it is resilient, suggesting that its benefits are also resilient. Digital means are convenient for some, even most, people: not necessarily for all. Diversity of opportunities and freedom of choice should be preserved. Cash also guarantees privacy like no other payment means can; privacy is harmful when it supports crime, but not all demand for privacy is criminal. Last but not least, cash is unique in that it requires no infrastructure to function (except the technology to produce the banknotes themselves). For this reason, cash is a valuable component of a diversified and sustainable payments ecosystem.

A banknote with legal tender status is a non-interest-bearing debt of the issuer: a state in most cases or a combination of states in more unusual circumstances, like today's eurozone. The state (the "seigneur" in the old times) can oblige its subjects to accept it even when debased (i.e., when its value deteriorates). In medieval China, where paper money first appeared, death was the penalty for those refusing to accept it. Seigniorage extracts value, tempting the state to print more script or debase coinage to pay for wars or court expenses. In modern advanced countries this temptation has been hemmed in by making central banks independent. Occasionally today some governments resort to the printing press, like that of Venezuela, which issued in early 2021 1-million-bolivar notes (then worth about 50 cents).

Later that year a new currency was introduced, ironically called the "digital bolivar," with banknotes showing six zeros less than the old ones. Today, cash is but a small part of all money in existence: roughly, no more than 10 percent in the United States and in the eurozone. Most of the burden and the privilege of offering monetary means and services is entrusted to commercial banks, whose role is discussed in Chapter 6. 

Banks, an Italian invention, spread over the whole of Europe during the Renaissance and are still the most important financial institutions in existence. Their activities span a broad range: payments, depository of savings, asset management, diversification, lending of first resort to individuals and firms, corporate-related activity and consulting, and others. Today their primacy as money issuers is increasingly challenged by new forms of digital money. To appreciate the role of banks as creators, managers, and stores of money, one needs to focus on three aspects of them.

First, they are private institutions. As such, they are subject to competition and incentives to innovate to enhance their efficiency. Second, their broad span of activity generates synergies: Payments are directly linked to deposits, deposits in turn often originate from lending activity, client networks demand multiple services, like portfolio management and consulting, and so on. The client base is the network where those synergies are exercised. Third, they have long-dated and multiple relations with central banks, on which they depend for reserve holdings, lending of last resort, open market transactions, prudential supervision, and so on. This linkage is critical to ensure the good functioning of money, a public good immersed in the private domain. We argue that the benefits stemming from this public-private mixed arrangement are important and difficult to replicate in any alternative setting. The enhancement of digital monies should therefore occur in a way that avoids any abrupt and uncontrolled disintermediation of banks.

Fortunately, this need not be the case. The most successful new digital forms of money are compatible with banks in fact, complementary to them. The "mixed system" comprising banks (the "private" side) and central banks (the "public" side) works well, in the sense that it has not impeded, actually it facilitates, technical progress in the field of means of payments. In Chapter 7 we review the main payment technologies in use today. We explain that this has coincided with the demise of the use of personal checks and, to a lesser extent, a decline in the use of cash for many types of transactions. We start with the oldest forms, credit and debit cards, and move on to more recent applications like PayPal, Apple Pay, Alipay, and Google Pay. It is important to look at them "from above," that is, from the perspective of the user, and "from below," what actually happens after the payment is made and until it is finally settled. All transactions using these applications have a counterpart in the movements of bank and central bank accounts; this guarantees their certainty and finality. While the "above" part is apparent, it is the "below" side which makes the system solid. Far from challenging the mixed private-public combination of banks and central banks, cards, apps, and online platforms are integral parts of that arrangement.

A similar arrangement can support cross-border payments as well. The euro area today is a unique example of a smooth, seamless cross-border payment area. We show that the payment system of the eurozone (including both its interbank and client-based components, Target and the Single Euro Payments Area) is characterized by an elevated level of efficiency, low cost, and high security for users, both domestically and across national borders.

By contrast, the US payment system still features a large use of personal checks and a high fragmentation and elevated fees applied to retail clients. We are inclined to consider the system of today's eurozone, as it emerged from over twenty years of construction and reform as state-of-the-art globally in terms of its retail efficiency and quality of service. 

In Chapters 8-10 we discuss the newest forms of digital money: cryptocurrencies, stablecoins, and CBDCs. The first two are private (and, as of today, unregulated). The third one is public, and as such fully regulated, and in most countries it is still at the planning or testing stage. These instruments differ from the earlier ones in that they are potentially an alternative to the existing arrangements: The complementarity element is less clear here, whereas the "competition" element is stronger. Crypto instruments and CBDCs are related to one another in the fact that CBDCs originate largely as a reaction to the perceived threats posed by crypto instruments.

Cryptocurrencies are the easiest to deal with in our context since they are not money in the sense we have tried to define. We review the developments of Bitcoin and other similar instruments, describing how they work and assessing them from the viewpoint of fulfilling the function of money. We conclude that they stand no chance of replacing money for any of its crucial functions. Over time, however, under certain conditions, they may establish themselves as a "niche" speculative asset class, potentially useful to complete the financial market. This outcome is possible but still uncertain, and out in the future.

Stablecoins are more difficult to assess, largely because they are still in their infancy. The most prominent among them, Libra (subsequently Diem), launched in 2017 by Facebook (now Meta), was eventually abandoned — a  sign that maybe this is not the future of money. Others survive and others are yet to be born. In essence, stablecoins are banks, just more specialized. Like banks, they offer a special service - liquidity transformation - which is both essential to the economy and risky. Their ambition is to offer instruments that are as safe as bank deposits, with associated payment facilities, backed by a pool of assets or by trading algorithms. The main concern about them is their fragility, inherent in the maturity and risk transformation that occur in their balance sheets. The risk is compounded by them being still unregulated and unsupervised unlike banks, with which they compete. However, were they regulated, they may find it difficult to compete with traditional intermediaries. We conclude that while the trade-off between security and cost does favor them in comparison to other crypto assets, the jury is still out, because the sector is still evolving and a proper prudential framework is still in the future.

Central bank digital currency is a catchword for proposals discussed in central banking circles at present to indicate digital cash issued by central banks. Leaving details aside, the basic idea is that CBDCs should be like bank deposits, except that they would be recorded in the books of the central banks rather than those of the banks. This would evidently short-circuit the complementarity between banks and the central bank. The two would end up offering similar services, thus becoming substitutes more than complements. No major central bank has yet issued a CBDC, with the partial exception of the People’s Bank of China. The main Western central banks - the Federal Reserve, the European Central Bank and the Bank of England - are conducting studies and will make decisions within the next few years.

In Chapter 10 we go deeper into the pros and cons of this idea. From the perspective of individual users, successful retail CBDCs would be indistinguishable from bank deposits. They could be supported by any of today's digital means (cards or apps). The person approaching the cashier in a store would have in their pocket another card or a smartphone app, which directly or indirectly (the precise way is unclear at the moment) would be linked to a customer deposit in the central bank. Payments could be instantly registered with a central bank and be interfaced through a bank acting as an operational platform. All the difference would be "below the surface," not visible to or understandable by the unsophisticated user. Assuming the central bank were able to remain technologically at the frontier - something which is far from granted - the CBDC would compete with other instruments, already established and which work well, without clear user advantages.

In Chapter 10 we go deeper into the pros and cons of this idea. From the perspective of individual users, successful retail CBDCs would be indistinguishable from bank deposits. They could be supported by any of today's digital means (cards or apps). The person approaching the cashier in a store would have in their pocket another card or a smartphone app, which directly or indirectly (the precise way is unclear at the moment) would be linked to a customer deposit in the central bank. Payments could be instantly registered with a central bank and be interfaced through a bank acting as an operational platform. All the difference would be "below the surface," not visible to or understandable by the unsophisticated user. Assuming the central bank were able to remain technologically at the frontier - something which is far from granted - the CBDC would compete with other instruments, already established and which work well, without clear user advantages.

We also discuss potential complications arising from CBDCs for monetary policy, financial stability, and other reasons. Given the limited advancement of CBDC projects, it is impossible to see what their future may be — if, in particular, they eventually see the light and find their niche in a complete and diversified payments ecosystem, or risks will arise which will outweigh their benefits.

In Chapter 11 we consider whether digital monies can redesign the boundaries between market forces and government, ultimately between individual freedom and public control in the monetary sphere. Supporters of this view often refer to the Austrian school, which in earlier centuries advocated free markets in both money management and banking. The digital revolution potentially makes steps toward "free banking" and privatized forms of monetary management easier. By contrast, CBDCs are a  

reaction to it, aiming at reestablishing central bank monopoly in a stronger form. Competition, advocates believe, can improve the quality of money. Privacy is a dimension of freedom: If a payment cannot be traced, it cannot be controlled either. But it can be socially harmful, if criminally motivated. We conclude that the scope of digital and crypto instruments to enhance freedom, competition, and privacy is limited at best. These instruments are all traceable; even if legal safeguards are put in place, they may not resist pressure toward disclosure. Competition always requires rules to function, and digitalization makes this need more compelling because it increases the risk of exploitation for opaque or fraudulent purposes.

In Chapter 12 we look at money as a weapon in global power strategies. The role played by monetary dominance in world politics is far from new: suffice to remind the importance of sterling as a pillar of the British empire in the nineteenth century and that of its successor, the US dollar, in the post-World War II world order. The weaponization of money has become more extensive in the twenty-first century: Banking systems and payment infrastructures, such as SWIFT (Society for Worldwide Interbank Financial Telecommunications), have been used, for example, as part of the war on terror and to uphold the sanctions against Russia during the Ukrainian war. CBDCs, it is sometimes argued, can foster the global role of the respective currencies. This idea adds fuel to the long-standing debate on whether the US dollar is declining as a leading global currency, possibly to be replaced by the Chinese renminbi or the euro. Currency dominance, we argue, has deeper-rooted determinants: the size of the economy, the breadth of financial markets, the efficiency and stability of banking and payment structures, the quality of regulation, and, more

broadly, the standing of the respective jurisdiction and the authority it commands on the global scene. No financial market today can compete with that of the United States once the full constellation of relevant characteristics is accounted for. It is unlikely that the mere digitalization of money, by an emerging power like China or even by Europe, could by itself be decisive. Over time, tectonic movements may occur, though. An efficient monetary digitalization can contribute, with other factors, to shifts in geopolitical power.  

In Chapter 13 we delve into the possible reasons for the acceleration in the digitalization of money observed in the last fifteen to twenty years. We identify those roots in the return of instability in the global economy and financial sector after decades of relative calm, sometimes called in academic debates "moderation." The launch dates of many digital start-ups are revealing: 2014 for Apple Pay and 2011 for Google Pay. The foundational document of Bitcoin by the pseudo-named Satoshi Nakamoto dates 2008. PayPal is older (1998), but its development phase really started after the spinoff from eBay (2014) and the launch of a new strategy as an independent platform. The financial environment after the financial crisis of 2007-08 provided a fertile ground for the rise of digital monies, in various forms. The crisis shattered public confidence in banks and other established financial institutions, encouraging solutions outside the traditional sector. The wave of bank regulation that followed the crisis facilitated the shift of resources and business toward the less-regulated financial sector, which became the cradle and incubator of fintech. Massive liquidity injections by the central banks compounded the process by fueling risky investment, part of which was channeled toward crypto markets. It also provided finance to corporate buyouts, part of which took place in the tech sector.

That phase has now ended; interest rates have returned positive and central banks are mopping up the mass of liquidity created by their "quantitative easing." Will the reversal extend to the digital money world? Shall we see a retrenchment in the use of digital monies, less innovation, and a return to traditional payment practices? Experience suggests that interest rate fluctuations often trigger new phases of financial innovation. A similar experience may repeat now. Online payment facilities will increasingly dominate the retail sector, with fierce competition among networks being fatal to many competitors, especially the smaller ones, leading to more concentration and market power. Cryptocurrencies and stablecoins may not have an easy life in the "new world" of higher inflation and interest rates. They may offer some value in diversified portfolios, especially if supported by regulation enhancing their transparency, protecting investors, and combating crime. In one sentence: Crypto instruments will not always be the same but will always be with us.

We conclude, in Chapter 14, highlighting possible future directions. We argue that central banks—partially independent and accountable agencies with a mandate and technical expertise—are not replaceable, in the foreseeable future, as guardians and administrators of monetary systems as they move deeper into the digital era. They should remain the base of a monetary pyramid that includes private banking institutions and a constellation of related and connected private payment solutions, constantly evolving and improving. The critical element to be maintained is the complementarity between the private and the public side of this construction. The first is the engine of innovation, the second ensures the competitive playing field and financial stability. A well-functioning monetary and payment ecosystem requires regulation and supervision. For the world of crypto, rules have to be set up from scratch - using experience from other areas. Innovation should be encouraged and, even before that, permitted. This is why, in our opinion, CBDCs are not helpful and may even become a threat. Competing with private providers from a privileged position (central banks are financed by taxpayers and cannot go bankrupt) they risk altering the playing field, upsetting the equilibrium between the private and public components and stifling technical progress. If CBDCs see the light eventually, they should be carefully designed in a way to preserve that equilibrium.